The Circular Flow

A simple model of the workings of an economy depicting the movement of resources between producers and consumers. A number of flows comprise the circular flow of income. First, there are the wages and salaries paid by firms to households. Secondly, there is the money spent by households and received by firms. Corresponding to each of these flows of cash is a flow of some resource in return - labour is provided by households to firms; goods and services are provided by firms for households. There is then a total of four flows in this highly stylized account of how economies function, and there is complete symmetry between the two sectors: households and firms. Each provides the other with some real resource and each receives cash in return; and each spends that cash on the supplies of the other. The same cash is spent by one sector and then the other continuously.

The flow begins with workers leaving their households and going to work at businesses. They not only bring with them their labor, but also all the other factors of production, including land (natural resources), capital, and entrepreneurial talent.

In return for the factors of production (resources or inputs), businesses pay incomes: wages, rent, interest and profits to the members of the households.

Together, the supply of resources and the payments for their use constitute the factor market. What do the businesses do with all those resources? Since we assumed no investment in new capital, no government, and no foreign sector, all they can do is produce consumer goods and sell them to households..

And what do the members of the households do with their incomes? Since we assume no savings, government, nor foreign sector, all they can do is spend the money on consumer goods -- consumption. Together, the provision of goods and the payment for them constitute the product market.

The total amount of goods and services that are produced, bought, and sold is equal...